Hoping for the best, preparing for the worst

Dylan Grice
Stratgiste Global

Distant relatives?

Ben Bernanke, chairman of the Federal Reserve Board, 2006-

Rudolf von Havenstein, president of the Reichsbank 1908-1923

Source: Google Images

Silver content of Roman coin as Imperial finances became increasingly strained

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 64-68

161-168

Didius Julianus, 193

Elagabalus, Pupienus & 219-222 Balbinus, 238

Philip, 244

Valerian, 255-60

Claudius II, 268

Source: SG Cross Asset Research2

The inflationary bias of policy: UK inflation down the centuries (log of retail price index)
10000 WW2 1000 Timber shortage
South American gold and silver WW1

100 Napoleonic Wars 10

1 1300

1400

1500

1600

1700

1800

1900

2000

Source: Phelps_Brown & Hopkins

Deflation is the tail risk here Discuss

100 90 80 70
Post WW2 average inflation rate Implied 30y average inflation "Great Moderation" average inflation rate

60 50 40 30 20 10 0
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Source: SG Cross Asset Research 4

Japanese vs US real GDP growth

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% 20 year annualised growth 10 year annualised growth Japanese GDP growth US GDP growth 5 year annualised growth

Source: SG Cross Asset Research

Japanese vs US real per worker GDP growth

1.8%

1.6%

1.4%

1.2%

1.0%

0.8%

0.6%

0.4%

0.2%

0.0% 20 year annualised growth 10 year annualised growth Japanese per worker GDP US per worker GDP 5 year annualised growth

Source: SG Cross Asset Research

Working age population projections: Japan seems a special case

250 230 210 190 170 150 130 110 90 70 50
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

France Germany Japan UK USA

Demographic slide accelerates

Japan goes over the demographic peak in 1995

Source: UN; SG Cross Asset Research 7

The problem of induction: that there have been no debt deflations doesnt mean there can be no debt deflations

Source: Mike Atkinson, Google Images

0% inflation floors pricing in significant CPI declines over next five years
1200 1000 US 5y inflation floors

800

Eurozone 5y inflation floors

600

400

200

Source: Bloomberg

Is the real deflation risk here a Chinese hard landing? Beijing land prices have risen 800% in the last 7 years
1000 900 800 700 600 500 400 300 200 100 0
2003 2004 2005 2006 2007 2008 2009 2010

72% annualised in the last two years

Source: Wu, Gyourko and Deng (2010)

10

The greatest credit inflation in financial history?

trRMB (cum 12m sum)

12

10

0 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010
Source: SG Cross Asset Research

11

Expensive insurance? S&P500 6m ATM volatility has been repriced since the crash

Source: SG Cross Asset Research

12

Cheap insurance? Hang Seng volatility well below its long-term average
80 70 60 50 40 30 20 10 0 04 05 06 07 08 09 10

Historical volatility since 1964

Source: SG Cross Asset Research

13

Our governments are insolvent

Official Net Debt, % GDP* Total net liabilities (on and off balance sheet), % GDP**

750%

500%

250%

0% Germany Spain France Italy UK EU US Greece * 2010 OECD projections ** 2005 estimates of total Fiscal Imbalance
Source: OECD, Gokhale (2009) 14

Japanese government tax revenues no longer cover non-discretionary expenditure

Bond issuance to tax revenue ratio (%)

Source: Japanese MoF; SG Cross Asset Research

15

10

12

14

16

18

0 M ex ic o, 1827 Spain, 1877 Argentina, 1890 G erm any , 1932 C hina, 1939 T urk ey , 1978 M ex ic o, 1982 Braz il, 1983 Philippines , 1983 South Afric a, 1985 R us s ia, 1998 Pak is tan, 1998 Argentina, 2001 G reec e, 2009 Spain, 2009 J apan, 2009 U S, 2009 Selected ratios today
Source: SG Cross Asset Research 16

2 Historical public debt/revenue ratios during selected defaults

If is easier than when There is no debt/revenue ratio crisis trigger point

Cheap insurance? JPY swaption volatility below historic average

Source: Japanese MoF; SG Cross Asset Research

17

Cheap insurance? USD swaption volatility below historic average

Source: Japanese MoF; SG Cross Asset Research

18

This time is different 1914 style

there will be no unlimited issue of paper money and its steady depreciation since monetary science is better understood at the present time than in those days.

New York Times on why the war which had just broken out wouldnt be inflationary, Aug 30th 1914

19

The inflationary bias of policy, or the illusion of control? log of FTSE All Share with financial crises (grey bars)
10000

1000

100

10

1
1880 1800 1810 1820 1830 1840 1850 1860 1870 1890 1980 1900 1910 1920 1930 1940 1950 1960 1970 1990 2000 2010

Source: SG Cross Asset Research, Kindleberger 20

Gold is cheap (% gold backing of US monetary base)

140% 120% Gold is expensive - USD overbacked by gold

100%

80% Gold is inexpensive - USD underbacked by gold 60%

40%

20%

0% Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: SG Cross Asset

21

10.0

1.0

log of Chinese agricultural productivity (tonnes per hectare)

Source: USDA, SG Cross Asset

1960/1961 1961/1962 1962/1963 1963/1964 1964/1965 1965/1966 1966/1967 1967/1968 1968/1969 1969/1970 1970/1971 1971/1972 1972/1973 1973/1974 1974/1975 1975/1976 1976/1977 1977/1978 1978/1979 1979/1980 1980/1981 1981/1982 1982/1983 1983/1984 1984/1985 1985/1986 1986/1987 1987/1988 1988/1989 1989/1990 1990/1991 1991/1992 1992/1993 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011

22

10.0

12.0

6.0

0.0

2.0

4.0

8.0

China rebuilding inventories after recent plunge (stock to consumption ratio, months supply)

Source: USDA, SG Cross Asset

1960/1961 1961/1962 1962/1963 1963/1964 1964/1965 1965/1966 1966/1967 1967/1968 1968/1969 1969/1970 1970/1971 1971/1972 1972/1973 1973/1974 1974/1975 1975/1976 1976/1977 1977/1978 1978/1979 1979/1980 1980/1981 1981/1982 1982/1983 1983/1984 1984/1985 1985/1986 1986/1987 1987/1988 1988/1989 1989/1990 1990/1991 1991/1992 1992/1993 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011

23

Chinese net grain imports as a % of cons.

10% 15% 20% 0% Chi nese dependency on world gra i n markets is s urging 5% -5%

but through imports rather than production (net grain exports as a % of consumption)

1960/1961 1962/1963 1964/1965 1966/1967 1968/1969 1970/1971 1972/1973 1974/1975 1976/1977 1978/1979 1980/1981 1982/1983 1984/1985 1986/1987 1988/1989 1990/1991 1992/1993 1994/1995 1996/1997 1998/1999 2000/2001 2002/2003 2004/2005 2006/2007 2008/2009 2010/2011
Source: USDA, SG Cross Asset

24

1.0

1.5

2.0

2.5

3.0

3.5

High and volatile grain prices ???

Grain inventories remain historically low; months supply of grains (and soybeans)

Source: USDA, SG Cross Asset

1960/1961 1961/1962 1962/1963 1963/1964 1964/1965 1965/1966 1966/1967 1967/1968 1968/1969 1969/1970 1970/1971 1971/1972 1972/1973 1973/1974 1974/1975 1975/1976 1976/1977 1977/1978 1978/1979 1979/1980 1980/1981 1981/1982 1982/1983 1983/1984 1984/1985 1985/1986 1986/1987 1987/1988 1988/1989 1989/1990 1990/1991 1991/1992 1992/1993 1993/1994 1994/1995 1995/1996 1996/1997 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011

25

What a temporary shock looks like

450 400 350 300 250
200

CRB food index spikes a fter poor Soviet harvest

Nomi nal food prices Rea l Food prices

150 100 50 0

... but real price decline resumes as shock dissipates

01/09/68

01/07/70

01/05/72

01/03/74

01/01/76

01/11/77

01/09/79

01/07/81

01/05/83

01/03/85

01/01/87

01/11/88

01/09/90

01/07/92

01/05/94

01/03/96

01/01/98

01/11/99

01/09/01

01/07/03

01/05/05

01/03/07

01/01/09

Source: USDA, SG Cross Asset

26

What a permanent shock looks like

50 45 40 35 30 25 20 15 10 5 0 1967 OPEC embargo during the six day war has no effect on oil prices 1973 OPEC embargo works like a dream ... (and oil prices never return to pre-embargo levels) 40%
US oil dependency (net imports as % of consumption)

Stable US oil dependency

Sudden increase in US oil dependency

Arabian light crude

60%

50%

30%

20%

10%

1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Source: SG Cross Asset

27

China now has more warships than the US !

28

Shillers cyclically adjusted PE shows the US equities still expensive

45
1st quintile (most expensive)

40 35
30

2nd quintile 3rd quintile 4th quintile

5th quintile (cheapest)

25 20 15 10 5 31/01/1881

31/01/1901

31/01/1921

31/01/1941

31/01/1961

31/01/1981

31/01/2001

Source: SG Cross Asset Research, Robert Shiller

29

10 year real returns based on the starting Shiller PE

0% 2% 4% 6% 8% 10% 12% 1 1.7%

5.3%

6.4%

7.2%

10.9%

Source: SG Cross Asset Research, Robert Shiller

30

Global IVP ratios suggest equity returns consistent with Shiller-based projected returns
1.2

Equities cheap
1.1

1.0

0.9

Equities expensive
0.8

0.7

0.6 required return = 8% requiredreturn = 10% 0.4 required return = 12% 0.3 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

0.5

Source: SG Cross Asset

31

Synthetic long-short returns to buying high IVP, selling low IVP

450 400 350 300 250 200 150 100 50 0 -50 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Cumulative long-short return

Source: SG Cross Asset

32

Sector IVPs (IVP>1 = cheap; assumes 10% required return)

Metal Producers Financial Automotive Oil & Gas Services Metal Product Construction Utilities Health Care Paper Diversified Electronics Chemicals Tobacco Publishing Retailers Miscellaneous Recreation Transportation Machinery Aerospace Food Beverages Apparel Textiles 0.0 0.2 0.4 0.6 0.8 1.0 1.2

Source: SG Cross Asset

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Conclusions:
Hope for the best
Pockets of value within equity markets: Overall equity markets are consistent with a 5% real return Some sectors look cheap Well-chosen stocks should be able to deliver more than the 5% on offer from the aggregate market Some insurance looks expensive enough to sell Mid-term developed market equity volatility is rich sell it on favoured stocks? Deflation insurance looks too pessimistic

prepare for the worst

Scarcity developing in key commodity markets Structural shift occuring in grain markets? Developed market governments are insolvent Low swaptions IVs suggest cheap hedge against bond market blow up? Government balance sheet problems have historically posed inflation risk LT upside equity OTMs to hedge Chinas credit growth and land price inflation are red-flags Downside HSI IVs looks attractive Is gold the ultimate insurance? (no counterparty default in 6000yrs!)

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